By: Linda Fisher, Senior Consultant
There is always a certain level of risk in lending, but construction loans are of even greater risk. The ultimate value of the collateral is realized only after the project is completed, and the finished project is either leased to a stabilized level or sold at a profit. Therefore, it is imperative that a construction loan be closely monitored to ensure that the project is successfully executed.
Why is construction monitoring so important?
Construction monitoring serves both the bank AND the customer. By conducting regular inspections, both parties can verify that the work being done is properly completed, on budget and results in the expected final value of the project.
Also, if for any reason there is a dispute or litigation arises, there is a record of independent monitoring of the project by a qualified third party that can aid in any conflict resolution.
When should a construction inspector be engaged?
While both the bank’s and the borrower’s responsibilities are outlined in the loan documents, a detailed discussion between the bank and the borrower should take place prior to closing that outlines how the draw process will be handled, and identify who will be conducting inspections and the costs associated with this service.
Subsequent to this discussion, the inspector should be engaged prior to closing. This individual should perform an initial review of the construction agreement, budget, timeline, and plans and specifications associated with the project. This helps to ensure that the proposed project is feasible given the work to be performed and can be completed within the designated costs and timeframe, as well as that all appropriate documentation related to the project is in order prior to closing the loan.
Throughout construction, having the construction inspector perform physical site visits provides independent verification of the line item percentage completion of the construction performed during the draw request period and due to the inspector’s expertise, allows the inspector to directly address pertinent construction matters with the contractors, architects and borrowers on the bank’s behalf.
Who is qualified to perform inspections?
Ideally, construction monitoring services are performed by engineers or other licensed individuals with experience in general construction methods and materials, as well as practices, techniques, and equipment used in building construction. A list of individuals/firms should be maintained by the bank – similar to lists of appraisers, attorneys, title companies, and other approved third-party vendors – that provide construction monitoring/inspection services.
As with any third-party vendor, these individuals should be thoroughly vetted, with documentation of his/her appropriate experience, references, and insurance.
A bank may sometimes engage the appraiser who performed the property evaluation prior to closing to serve as the construction inspector. While this individual may meet the intent of having an independent third party visit the site, an appraiser does not have the appropriate experience and training to review and interpret the plans and specifications prior to closing or effectively evaluate and monitor the construction as it progresses.
Who is responsible for payment of a construction inspector’s services?
The cost associated with utilizing a construction inspector is typically borne by the borrower and is included in the project budget as a soft cost and as a closing statement line item.
What do these services cost?
The best answer is…it depends. Costs for a construction inspector’s services will vary in conjunction with the location and scope of the project. The initial cost for a review of the plans and specs is typically a higher expense, with monthly periodic reviews as disbursement requests are received by the bank from the borrower being a lesser cost. The cost pales in comparison to the potential risk of having a project be inappropriately completed, stall mid-construction or potentially turn litigious costing time and expense for the borrower, contractors and the bank.
What are best practices in monitoring a construction loan?
Every step of the process should be well documented within the loan files. In addition to maintaining copies of the construction agreement(s), as well as original budget and timelines, details of change orders, a copy of the agreement with the construction inspector and any related information should be maintained as well. A copy of each loan disbursement request should be kept in the file and accompanied by the following:
- Inspection report – to include the name and title of the person that performed the inspection, the time & date of the inspection, captioned photos of the project, estimated percentage of project completion with supporting descriptions of work completed since the last inspection and materials stored onsite, details of any delays, disputes or inspector concerns, an estimated date of completion and the inspector’s approval of the requested disbursement
- Lien waivers/title bringdown/endorsement – to ensure that there are no intervening liens filed against the project
- All paid or owing invoices, receipts and other verifications of project expenses or applicable borrower reimbursements
- Updated budget – demonstrating percentage of completion of budgeted expense categories, and sources and uses of equity and debt funds to date.
Maintaining this information in the file demonstrates that the bank is effectively monitoring the loan and provides clear documentation of progress of construction. If a question or concern develops, it can be quickly and efficiently addressed, since the information is secured in one location.
What is a certificate of final value?
Upon completion of the construction/issuance of the certificate of occupancy, the bank should inform the original appraiser of such completion and a final inspection performed by the appraiser to validate that the project was completed within the parameters defined in the original appraisal. The appraiser then issues a certificate of final value correlating the completed project to the circumstances of the appraisal report and its concluded “as complete” value.
Building Confidence With a Construction Monitoring Plan
An effective, consistent construction monitoring program avoids surprises for all parties, as it documents the evolution of the project, from the initial approved scope and costs, throughout construction and to final completion. Prior to closing, all parties can be confident knowing that they are starting off on the right foot, with a solid and achievable plan. As the project progresses, any issues that may arise can be identified and dealt with appropriately. Given the potential risks associated with any construction project, having a solid plan and maintaining proper documentation provides a higher probability of a successful outcome that benefits both the borrower and the bank.
Optimize Your Construction Loan Management Strategies with Y&A
Young & Associates offers specialized lending and loan review services to assist community banks and credit unions in constructing robust construction loan management and administration processes. For tailored solutions and expert support, contact us here. Strengthen your construction loan approach with Young & Associates’ dedicated expertise.
